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What is a Vertical Analysis of an Income Statement and Why is it Important?
Statistically, in 2021, the global financial analytics market size exceeded $9 billion. It is also expected to grow at an annual compound annual growth rate of around 15% from 2022 to 2030. This highlights the increasing significance of mastering financial analysis techniques, including a thorough analysis, to stay competitive in today’s financial landscape. One can consider vertical analysis income statements as a prominent approach, as it compares the relative importance of different line items on an income statement.
For financial managers and business analysts, vertical analysis is also responsible for overseeing an organization’s financial performance and analyzing financial data. Let us dive in to know more.
What is a Vertical Analysis?
Vertical analysis is a financial analysis technique that examines the proportions of each line item in the income statement relative to a base figure to evaluate a company’s financial statements. Additionally, the base amount is often the overall revenue or sales (for the time period under consideration). Hence, it determines the relative importance of various elements in financial statements and to find trends and patterns (further use to make financial decisions).
Why is Vertical Analysis Important for Financial Analysis?
Vertical analysis provides a clear and concise picture of a business’s financial performance. This, in turn, makes it easier for financial analysts and managers to identify trends, patterns, and areas for improvement. Other than this, it accomplishes the following:
- Vertical analysis enables a comparison of the financial statements of different companies as well as the same company
- Additionally, it identifies trends as well as patterns in a company’s financial performance over time
- Moreover, it highlights areas where a company may be underperforming or overperforming and helps identify areas where improvements can be made
- Lastly, vertical analysis promotes effective comparison among the financial statements of different companies operating in the same industry, making it an ideal tool for investors before making investments
How to Apply Vertical Analysis to Income Statements?
Financial analysts must also express each line as a percentage of total revenue to apply vertical analysis to income statements. These are the following steps they need to take:
- Begin by gathering the financial statements, specifically the company’s income statement for the time under consideration
- Secondly, determine the total revenue for the time period under consideration and use this as the starting point for the analysis
- To calculate the percentage of each line item, divide the total income by the amount of the line item and multiply by 100
- Next, on the income statement, add a new column called vertical analysis and write the percentage of total revenue for each line item
- Subsequently, examine the vertical analysis column to learn more about the company’s financial performance
|Line Items||Amount||Percentage of Revenue|
|Cost of Goods Sold||$300,000||60%|
|Income Tax Expense||$30,000||6%|
The cost of goods sold accounts for 60% of total revenue, indicating that the company can have a high production cost or a low selling price. Moreover, the operational expenses account for 24% of total sales. Also, they imply that the company’s operational costs should be reduced to enhance profitability. Furthermore, the vertical analysis also reveals that net income accounts for only 4% of total revenue, suggesting that the company’s overall financial performance might be improved
ALSO READ: Mastering Accounting and Financial Management for Career Success
How Does a Vertical Analysis Income Statement Differ From a Horizontal Statement?
Simply put, vertical analysis and horizontal analysis are both financial analysis tools used to evaluate a business’s financial statements, but they still differ in many ways.
|Basis of difference||Vertical Analysis||Horizontal Analysis|
|Approach||Expresses all line items as a percentage of a common base figure, usually total revenue or total assets||Compares financial statements over a different time period (typically year-over-year or quarter-over-quarter)|
|Focus||Concerned with determining the relative importance of each line item in the financial statements||Focused on recognizing changes and patterns over time|
|Use||Useful in comparing financial statements from different companies. Also used for assessing a company’s financial performance over a specific time period||Beneficial to assess a company’s financial performance over time|
Vital Ratios From Vertical Analysis on Income Statements
Vertical analysis of an income statement provides the basis for calculating several financial ratios that help assess a company’s financial performance. Specifically, the ratios derived from this analysis include:
Gross Profit Margin
The profit made for every dollar of sales revenue is the gross domestic margin. Notably, it is determined by dividing total sales by gross profit and expressing the result as a percentage.
Operating Profit Margin
It is the percentage of sales revenue left over after subtracting operating expenses. Moreover, it is determined as a percentage of total revenue by dividing operating income by total revenue.
Net Profit Margin
It is the percentage of each dollar of sales revenue that remains after all expenses, including taxes and interest, have been deducted. Furthermore, it is determined as a percentage by dividing net income by total revenue.
Return on Assets (ROA)
Simply put, it is the proportion of net income created for every dollar of assets a business uses for various purposes. It is determined as a percentage by dividing net income by total assets.
Return on Equity (ROE)
The percentage of net income earned for each dollar of shareholder equity is calculated as the return on equity. One can thus determine the return on equity as a percentage by dividing the net income by the shareholder equity.
Can Vertical Analysis Income Statements be Used for Non-Profit Organizations?
Vertical analysis remains the same regardless of the type of organization. However, the specific line items on the financial statements for non-profit organizations may differ from those for for-profit organizations.
Grants, contributions, and fundraising efforts are common sources of money for non-profit organizations. As a result, the revenue portion of a non-profit’s income statement may differ from that of a non-profit firm. Similarly, non-profit organizations’ expenses may vary from those of for-profit businesses.
Non-profit organizations can use vertical analysis to analyze their financial accounts and uncover trends and patterns in their revenue and expenses. This can also assist them in making informed financial management decisions and identifying areas where they can improve their financial performance.
Overall, vertical analysis can be helpful for both for-profit and non-profit organizations in financial analysis.
Navigate the Financial Landscape with Emeritus Courses
Vertical analysis income statements are very important for financial analysts who must communicate financial information to investors, board members, and employees. However, navigating the complex financial matrix can be challenging for these experts and analysts. This is why it is essential to identify and learn from the most efficient finance courses.
Emeritus’ online finance courses are therefore relevant to the ever-changing financial world. Furthermore, these finance courses suit learners at every stage of their careers (from entry-level professionals to experts), whether they want to master finance, explore fintech innovations, or gain insights into wealth management.
By Vasudha Awasthi
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